Accessing Hidden Liquidity in Modern Markets


U.S. equity market participants operating in an increasingly complex market structure, characterized by a broad range of venues to trade which includes 16 exchanges (for now) and more than 50 alternative trading systems (ATS) and dark pools.  The complexity creates significant execution challenges for traders including where to trade for the lowest fee, where to find the best price for a security and perhaps most importantly for large trading accounts how to trade without impacting market quality.

Equity trading has become increasingly fragmented.  Not only is liquidity segmented into lit and dark venues, but it also is being segregated from the general public through the use of single dealer platforms and internal matching systems hosted by wholesalers.  Accessing non-displayed liquidity is challenging investors, as they attempt to navigate the tiered trading landscape.

In effect, the non-displayed liquidity has become inaccessible to a broad segment of the market, which is not only impacting their ability to trade in size but ultimately is impacting their execution quality.

As such, U.S. exchanges are under constant pressure to innovate, especially as competition builds from both existing and new exchanges.  Add to that the rising presence of dark pools and the challenges facing U.S. exchanges are clear.  Innovations include both improved technology, fee structures and increasingly new order types that provide market participants with transparency, order protection and lower costs.

Navigating the complexity requires even the most sophisticated trader to engage a roster of brokers, technology and trading tools to support access to liquidity.  It is not just about identifying where there seems to be an abundance of liquidity.  Lowering total trading costs is more than just executing for the lowest commission or fee. Traders need to balance their execution strategies against the potential impact their order may have on market prices.

Once contra parties start sniffing out your intentions, they adjust their pricing to reflect the change in demand, with an immediate impact on prices as you work in or out of a position.  As such, strategies need to be judicious in how they approach their trading, seeking out the best place to get the trade done with the least amount of market impact.  The challenge is more than just identifying the exchange with the deepest pool of liquidity, it requires a multifaceted analysis of what type of orders may be traded in a specific venue including type of firm, type of security and imbedded business model of the trading venue.

Traders need to be aware of the types of firms trading on an exchange or ATS.  Although exchanges represent a mix of different types of order flow from retail investors, institutions and broker dealers, the constituent participants in a ATS can be segmented, especially if the ATS has trading rules and characteristics that attract a certain type of participant.


Regulatory Challenges: Reg NMS and Reg ATS

The complexity is made significantly worse by the current regulatory structure, which treats the operation of these two types of execution venues very differently, with exchanges held to one standard under the SEC’s Regulation NMS while ATS’s are regulated as broker dealers under Regulation ATS, creating what has become an increasingly uneven playing field between the two types of venues.  And when you add in single dealer portals and wholesalers that internalize liquidity, you create even more disparity between each type of execution venue, especially since single dealer portals and wholesalers adhere to different rule books which can provide subtle advantages over both dark pools and exchanges.

Dark pools are generally subject to less stringent regulatory requirements, especially around the types of orders and trading priorities within their matching algorithms.  Each dark pool operates under a different rule set.  Although these rules are filed with the SEC and available for public review, the rule sets allow for considerably flexibility in terms of segmenting customers, fee structures and preferencing of order flow.  And given that dark pools are operated under individual broker dealers, the flexibility allows them to frame trading rules to most benefit the types of order flow the pool operator controls.

For example, dark pools provide segmentation to classify client liquidity. Venue Participants are categorized by type (Institutional, Retail, or Proprietary) and or execution toxicity. The venue operator and participants can then designate which participants with which they are willing to interact.  Segmentation also allows for the Broker-dealer operating the trading venue to internalize client orders, thus avoiding fees they would otherwise be subject to if the trades were executed on exchanges.

In essence, since dark pools operate outside of the regulatory framework governing the operation of exchanges, they can (and do) leverage operational protocols that provide a competitive advantage over exchanges.  For example, dark pools can elect not to route to other market centers or dark pools, effectively capturing that order flow and limiting market wide exposure, especially since dark pools are not required to publicly post bids and offers.


Off-Exchange Trading Volumes at Record Levels

Changing order routing practices and the inherent competitive advantage dark pools are able to leverage have led to a growing share of volume occurring off exchange.  The proportion of volume trading off exchange has been steadily increasing in recent years, reaching a record 45.8% in January 2021 (see Exhibit 1). Other metrics related to trading off exchange are also at or near record levels including when measured by both notional value traded and number of trades.



Competitive Responses from Exchanges

Exchanges are addressing these challenges by providing tools and mechanism to create less conflicted and more neutral trading eco-systems.  Not just in open, lit books but also through order types which can help traders disguise intentions and facilitate best execution and pricing parameters.  Exchanges can have certain advantages when implementing these tools, including pre-existing connectivity with clients and established reporting mechanisms.

Other efforts by exchanges include the introduction of non-displayed order types that effectively segment trading into walled-off micro-exchanges, with the added benefit of allowing any existing exchange participant to enter.  The intent is to allow exchange participants to interact with like-minded counterparties.

These new order types are designed to both address the needs of clients but also to convince regulators the orders fit into existing market segments and trading protocols and provide optionality not seen before on exchanges. The nuanced facets of each exchange’s order types are many, but several products introduced in recent years are designed to compete against the advantages enjoyed by dark pools and their ability to segment. These efforts include the launch of different order types, such as non-displayed, pegged to NBBO, and orders which can be held for short periods to avoid adverse selection with certain types of liquidity (see Exhibit 2).


In a future article, Burton-Taylor will examine a number of innovative orders being offered by U.S. exchanges that are designed to compete against the advantages enjoyed by dark pool operators.


Andy Nybo is the Managing Director at Burton-Taylor International Consulting and has more than 30 years’ experience in research and technology in global capital markets.  Andy joined Burton-Taylor in March 2017 and focuses on the global exchange industry and how competitive pressures are forcing shifts in business models and strategic initiatives of exchanges.

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